How to Fairly Punish Bad Banks

Three simple steps to making the world a better place for everyone.

Let me start with some facts, often shunned in first paragraphs, but required here. UBS(NYSE:UBS) is on the verge of paying a $450 million -- possibly much more -- fine for rigging LIBOR. Citi(NYSE:C) is being investigated for the same thing, but in a bigger way. Barclays(NYSE:BCS) took a $450 million hit earlier in the year for LIBOR-related charges. HSBC(NYSE:HSBC) is $1.5 billion in the hole for money laundering, this year. Assuming Citi ends up being in a common boat with Barclays and UBS, that's about $3 billion in fines, in one year, between those four banks.

Investors have had just about enough, and the stocks have been hammered this ye-- What's that? Oh, I see. UBS is up over 45% this year, Citi is up close to 40%, Barclays up almost 60%, and HSBC is dragging the pack down, up only 35% or so.

Well, hell.

Almost everything about this article is depressingLet's talk about being bad first. Why are banks -- or anyone who premeditates a crime -- doing bad things? Put simply, it makes sense to be bad. Take the value of being good, and say that if the bank does what it's supposed to do, it makes $X. If it does something bad, it makes $(X +Y). But if it does something bad, there's a chance it's going to get caught, C%, and pay a fine $Z. So then it just weighs the whole thing up and if $(X + Y)-(C% * $Z) is greater than $X, it makes sense to be bad. Sometimes, the punishment isn't even as much as the extra money made, so you might as well go ahead and do it.

Good start. We can see why banks are cheating. Now, why are investors putting up with it? There are three things that investors like about banks, especially in this economic environment. First, banks make a lot of money, even when they get fined. Citi put up $468 million last quarter, and analysts are estimating that the bank will continue to grow at 10% over the next five years.

Investors also like that banks seem to be undervalued. Just a simple Google search for "undervalued bank stocks" returns hundreds of recent articles, many of which focus on the "if everyone is scared, now is the perfect time to buy" mentality. As an added bonus, banks have absolutely huge amounts of capital, making them virtually indestructible.

Which segues to the third great reason to buy banks: governments. This is pure conjecture, but I think you can buy JPMorgan Chase(NYSE:JPM), and never lose a night's sleep. Because it's one of two clearing banks in the U.S. that can handle tri-party repos, CEO Jamie Dimon could probably call every customer individually, threatening to kidnap their pets unless they forked over 90% of their personal savings, and the bank wouldn't be hurt. Too big to fail is like magic, free insurance.

A plan is devised Going back to the original problem, banks seem to be able to get away with murder -- or the financing of -- while booking huge sums of income and appreciating in value. The fines being levied are too small, and there are no good oversights in place, since the banks are policing themselves. We've already seemingly given up on breaking up banks, and we can't fine them too much because you don't want to actually put them out of business, just teach them a meaningful lesson.

When we punish people, we take away a meaningful amount of money -- or we take their time, and I think that's the solution to the problem with banks. Regulation is the one thing I have ever seen Dimon rail against, because regulation slows things down. In fact, that's the goal of lots of regulation, to slow everything down and take a close look at what's actually happening. Earlier this year, Dimon said, "I have this great fear that someone's going to write a book in 10 or 20 years, and the book is going to talk about all the things that we did in the middle of a crisis that actually slowed down recovery."

His focus in that speech was on job creation, which comes through lending, which means more profit for banks. Slowing down lending slows down profit and, Dimon thinks, job creation. But that's only true if it's universal, if every bank stops lending and credit simply isn't available. But if a few banks are lending easily, and a few are in tough times, then credit is still available. So, what if we did three things?

Problem solvedFirst, we increase how much we fine banks for messing around. That's simple. It doesn't have to be ridiculous, just meaningful. HSBC shrugged off the $800 million is set aside last quarter, so make them pay twice as much. It's not a company killer, but it hurts a bit.

Second, we're going to have step increases in capital requirements for banks that break the law. The rules are there to manage risk, and to ensure a level playing field. If you can't abide by the rules, then you're a bigger risk to the economy and the population. Being too big to fail might not "cost" anything, but if you abuse the right, then increased capital requirements can make you pay. Bump it up each major violation, based on the size of the risk incurred.

Finally, put banks in timeout. Investors want growth, and regulation slows growth. That's how you take the bank's time as punishment -- with a series of strict oversight regulations that only apply to banks that break the law. The bank moves slower under the regulatory environment, so investors have a reason to stop rewarding bad behavior. It also acts as a real deterrent to crime, since the people who have the most to lose with stock price drops are the people at the top.

And there you have it, three simple steps to making the banking world better, safer, and fairer.